“New Normal” is morphing into “Paranormal,” argues Gross
In his latest edition of his monthly newsletter, Bill Gross waves goodbye to the “New Normal” and adopts the “Paranormal”.
The following are a few excerpts from the report:
The New Normal, previously believed to be bell-shaped and thin-tailed in its depiction of growth probability and financial market outcomes, appears to be morphing into a world of fat-tailed, almost bimodal outcomes.
A new duality – credit and zero-bound interest rate risk – characterizes the financial markets of 2012, offering the fat left-tailed possibility of unforeseen policy delevering or the fat right-tailed possibility of central bank inflationary expansion.
The critical question of course is whether efforts by the ECB, BOE, and Fed will work. Can they reinvigorate animal spirits in the face of “credit” and “zero bound money” risk? We shall see. An investor however should hedge his/her bets until the outcome becomes more obvious.
1. Durations and average maturities should be at their maximum permissible limits. Even if reflation is successful it will only be because the Fed and other central banks keep policy rates low for an “extended period of time.” Financial repression depends on negative real yields and until inflation moves higher for a period of at least several years, central banks will hibernate at the zero bound
2. The bulk of sovereign bond holdings should be in the U.S. as long as Euroland credit implosion is possible investors should gravitate to the “cleanest dirty shirt” sovereigns with the least encumbered balance sheets. Anything short of a 5-year maturity however yields relatively nothing and provides minimal rolldown. Focus on 5–9 year Treasury maturities to guard against inflation which create opportunities to take advantage of rolldown capital gains.
3. Long Treasury maturities should be held in TIPS form. If inflation really is coming, then an investor will want assets that offer inflation-protection.
4. Corporate credit purchases should be in higher-rated A and AA paper. Senior as opposed to subordinated holdings in finance/bank debt should be considered as well. Haircuts ahead?
5. U.S. municipals represent an opportunity from the stand point of valuation. Their yields of 5–6% are near historically high ratios to Treasuries. They do, however, entail risk – not only volatility but occasional default risk. This is not a Meredith Whitney echo but simply a recognition that you usually get what you pay for in this world and nothing comes for free. Be selective and avoid states/municipalities with pension and funding problems.
6. Continue to avoid Venus fly trap peripheral Euroland paper. Italian bonds at 7% for instance are enticing but have trap door possibilities that could see further “price” defaults in 2012.
Stocks and commodities
1. Stocks yield more than bonds and will tend to do better in anything but a delevering fat left tail. That, however, is what worries us. Equity allocations, therefore should favor higher yielding companies in sectors with relatively stable cash flows: Electric utilities (yes they appear overbought), big pharma and multinationals should head your shopping list.
2. Commodities could go either way depending on the tails but scarcity and geopolitical considerations (Iran) favor a positive tilt. Gold at $1,550 seems pricey but it has upward legs if QEs continue.
The dollar is king with a left-tailed delevering scenario – pauper in a right-tailed global reflationary expansion.
For 2012, in the face of a delevering zero-bound interest rate world, investors must lower return expectations. 2–5% for stocks, bonds and commodities are expected long term returns for global financial markets that have been pushed to the zero bound, a world where substantial real price appreciation is getting close to mathematically improbable. Adjust your expectations, prepare for bimodal outcomes. It is different this time and will continue to be for a number of years. The New Normal is “Sub,” “Ab,” “Para” and then some. The financial markets and global economies are at great risk.
Click here for the full article.
Bill also shared his views in the following interview with The Wall Street Journal:
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